PROFIT AND CONTINGENCIES (FIN-28) Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Seminar on Rate Making San Diego, CA March 9 & 10, 2000

Contents Statement of Ratemaking Principles Surplus - Its Role and Characteristics Parallels With IBNR and Investment Income ROE Compared to ROP Regulatory Issues More Important Model and Technical Issues “Building Blocks”: The Fundamentals Important Recognitions / Attributes of a Complete Rate of Return Model Simplified Ratemaking Spreadsheet

Statement of Actuarial Principles Definitions Ratemaking is the process of establishing rates used in insurance or other risk transfer mechanisms. This process involves a number of considerations including marketing goals, competition and legal restrictions to the extent they affect the estimation of futures costs associated with the transfer of risk. This Statement is limited to principles applicable to the estimation of these costs. Such costs include claims, claim settlement expenses, operational and administrative expenses, and the cost of capital. The underwriting and contingency provisions are the amounts that, when considered with net investment and other income, provide an appropriate after-tax return.

Principles (continued) Considerations Risk The rate should include a charge for the risk of random variation from the expected costs. This risk charge should be reflected in the determination of the appropriate total return consistent with the cost of capital and, therefore, influences the underwriting profit provision. The rate should also include a charge for any systematic variation of the estimated costs from the expected costs. This charge should be reflected in the determination of the contingency provision.

Surplus - Its Role & Characteristics Prospective & multi-year - Upon writing business, surplus is committed for several years, for as long as associated liabilities (e.g. loss reserves) remain Risk focus - Financial cushion dictated by uncertainty and volatility (over the financial life of the policy) Generally true that the entire company surplus remains in support of all lines and locales (and policy periods), however, exceptions are when separate legal entities are used in writing business, and when reinsurance is line or locale specific, the entire net surplus is not available to all lines and locales.

Surplus - Its Role & Characteristics Surplus exists at the overall company level, yet it must provide a financial cushion for each of the policy-based risks of the company. Thus the aggregate amount of surplus is influenced by the different liability, risk and volatility characteristics inherent in the composition of policies written in regards to lines of business and locales, the largely additive increase in surplus that every policy written requires to support it, offset by benefits of diversification (covariance)

Surplus Role in Ratemaking - IBNR, Investment Income and Surplus Parallels Exist at aggregate company level, not by policy Introduced into rate making process via formula (i.e. on a marginal basis) Important component of company financial performance and strength Relevant to ratemaking and solvency THE QUESTION: How and at what level should these variables be reflected in the ratemaking process?

ROE Compared to ROP Alternative statistics, not necessarily alternative approaches or results “Fairness” reference - total return is a more widely recognized marketplace standard comparable to other industries (e.g. 15% ROE) than is return on premium Directly reflects cost of capital in ratemaking Total return provides a connecting framework between prices and the maintenance of adequate solvency margins by insuring that surplus growth resulting from premiums charged is adequate

Regulatory Issues Achieving a balance between fair / competitive rates and solvency Price regulation receives more publicity and is higher on activist agenda than is solvency regulation Reduction in prices and returns adversely impacts financial strength and solvency Subsidization occurs when states suppress prices below levels needed to support growth and to maintain solvency margins, resulting in subsidization by other lines of business or states

“Building Blocks”: The Fundamentals Balance Sheet, Income and Cash Flow Statements Accounting Valuation: Conventional (statutory or GAAP) and Economic (present value) Development “Triangles” of Marketing / Policy / Accident Period into Calendar Period

Important Recognitions / Attributes of a Complete Rate of Return Model The process by which value is created and reported earnings subsequently delivered in an insurance company, suggests that that the following characteristics should be recognized in any complete insurance financial model: (1) The manner in which originating policy / accident period actions create financial results that emerge over subsequent calendar periods. (2) The way conventional accounting differs from economic accounting rules with respect to the timing of income recognition.

Important Recognitions / Attributes of a Complete Rate of Return Model (Continued) (3) Specific shortcomings of reported financial elements. (4) Economic valuation concepts, particularly discounted cash flow. (5) A risk / return tradeoff-based decision framework within which capital requirements and rate of return targets are managed. Model output to include integrated and consistent set of important statistics such as: conventional and economically based measures of return (e.g. IRR and ROE), return on premium, and any others of interest.

Simplified Ratemaking Spreadsheet